The Corporate Bond Market: Binge-Borrowing

Celery and raspberry? Marathon miles of Sudoku and crossword puzzles? Extra reps at the gym? Binge away.

‘Tis the season after the season, that other most wonderful time of the year when it’s a challenge to get a machine at the gym and resolutions are resolute, at least until February or a more intriguing deal comes along. What better way to make amends for that huge holiday hangover that crescendos with so many a New Year’s Eve bash?

Some of us chose to ring in 2017 in a substantially more subdued manner that nevertheless entailed binging of a decidedly different derivation. Enter Netflix. Yours truly must confess that closet claustrophobia was the culprit in keeping this one indoors coveting the control, confining the choices to richly royal romps. It all started innocently enough, with a recommendation to catch The Crown, which has just won a Golden Globe. The devolution that followed began in Italy, with Medici, stopped over in France, with Versailles, and round tripped back to England, with the epic saga that kicked off the modern day, small screen genre, The Tudors. At some point hallucinations began to give the impression that all the series’ stars had British accents. Wait, they actually did.

Thankfully, at some point, bowl games snapped the spell and reality rudely reared its redemptive head before anyone’s else’s head rolled (those royals were a bloodthirsty lot!). Sleep and sanity followed.

Sadly, the same cannot be said of borrowers of almost every stripe these days. For those tapping the fixed income markets, the borrowing bingefest is conspicuous in its constancy. Not only did global bond issuance top $6.6 trillion last year, a fresh record, sales are off to a galloping start thus far in January.

In the lead are corporate bond sales, which accounted for $3.6 trillion of last year’s super sales. To not be outdone, investors ran a full out sprint in the new year’s first trading week, “shattering,” not breaking records, in the words of New Albion Partners’ Brian Reynolds. In the first three trading days of the year alone, investors bought $56 billion of new corporate bonds. Some context in the context of what’s been one record-breaking year after another in issuance:

“An average month in recent years would see investors buy about $130 billion of corporate bonds,” noted Reynolds. “Investors just bought more than 40 percent of that monthly average in just three trading days!”

For those of you who have ever had the pleasure of a good, long visit with Reynolds, he is anything but prone to using exclamation points. (!)

In any event, waves of heavy issuance often coincide with big deals carrying ‘concessions,’ or enticements in the form of higher yields than what the issuer’s existing bonds offer. Despite 2017’s already extraordinary deal flow, a good number of issues stood precedence on its head, coming out of the gate with negative concessions. “It’s as if corporate bond buyers are rabid, as if there are not enough corporate bonds to go around, even though there is a record amount of corporate bonds!” added Reynolds.

The kicker – there always is one when fever sets in – is that issuers are earmarking proceeds as generically as they can, for “general corporate purposes.” In other words, they can use the sales proceeds for whatever they desire, including share buybacks.

But wait! (Can exclamation points be contagious?) Haven’t we just learned that buybacks took a nosedive in the latest Standard & Poor’s data release? That quarter-over-quarter share repurchases had fallen by 12 percent and tanked by a stunning 25.5 percent over 2015’s third quarter? What superb sleuthing you’ve done, Watkins!

And right you are, except this one little thing. The pre-election world is so passé.

What are the odds share repurchases reaccelerate under the new administration? In one word ‘growing,’ fed by two springs. The first is mathematically driven. Calpers, the country’s largest pension, recently announced it would be “gradually” lowering its rate of return target to 7.0 percent from 7.5 percent. In the nothing-is-free department, estimates suggest taxpayers will have to cough up an additional $2 billion per year to make up for what the pension no longer anticipates in the form of pension returns.

(Suspend reality as the pension returned 0.61 percent in its most recent fiscal year ended June 30. We could ride off on a tangent but link to this if you’d like to hear more on pensions’ prospects http://ift.tt/2jwhLFk)

The funny thing is California governor Jerry Brown just announced he anticipates the state will run a $1.6 billion deficit by next summer as the tax base continues to atrophy driven by – wait for it – rising taxes. And where are a lot of those tax dollars going? You guessed right again – backfilling that yawning pension gap. Will the exodus out of the Golden State continue, leaving only the uber-wealthy and economically immobile behind? You tell me.

Promise there’s a point here. Calpers will lead the way to other pensions also lowering their rate of return targets, which will in short order trigger more in the way of rising taxes and, it follows, more actual monies pensions allocate to fresh investments to thereby generate those fairy tale returns. To stay deeply deluded and convince oneself (still) high returns are achievable, the de rigueur investment is private equity credit funds in their many high voltage varieties. At Reynolds’ last count, pensions have voted a record dollar amount into credit every single month since the stock market panic of 2015.

And the momentum just keeps building. December 2015’s record pension credit fund inflows of $7.3 billion were blown to bits by this past December’s $10.6 billion – and that’s before any leverage is put to work. As we have hopefully learned, the credit machine feeds the buyback machine, and away we go.Tack on the prospects of a Republican Congress facilitating the repatriation of all that offshore cash and you’ve got the makings of a true buyback renaissance. Oh, and by the way, a seriously overvalued bond market.

Jesse Felder, president of Felder Investment Research, recently put pen to paper to quantify the value investors get today. What sets Felder apart from the crowd, in a good way, is that he factors in the backdrop of record bond issuance feeding what had, until very recently, been a record pace of share buybacks.

“When you look at corporate valuations more comprehensively, including both debt and equity, we have now matched that prior period,” Felder wrote in a recent report, referring back to peak dotcom bubble valuations. To arrive at this conclusion, he compares the value of nonfinancial corporate debt and equity relative to gross value added, an effective gauge of enterprise value-to-sales.

How does Felder calculate such a clever metric? With the help of some Federal Reserve data, no less, he incorporates the buyback bout to create a holistic valuation methodology to capture comprehensive corporate valuations. Because one frenzy, bond sales, has fed the other, the stock market’s historic run by way of share count reduction, it’s simply disingenuous to not marry the two. You can want to try, but it’s futile to examine bond or stock valuations in a vacuum.

“This has essentially been a massive debt for equity swap that serves to reduce the value of equity outstanding while greatly expanding the amount of debt outstanding,” added Felder. “Equity-only valuation measures fail to account for this phenomenon. This measure incorporates it.”

The point, though, is not that the current rally will necessarily buckle under the weight of bloated valuations. To the contrary, pensions’ sheer buying power, their trillions upon trillions of dollars of monies to be allocated, can indeed make it appear that we are now in 1999, or better yet, 1996. But don’t be fooled – you’re still paying a dear price to play with fire.

So stop yourself the next time you hear some talking head reassuring you that the price-to-earnings ratio on a trailing 12-month basis is dirt cheap. Fight the temptation to validate your sense of security by proclaiming, “Wow, that erudite expert has some set of lobes!” Don’t just move on to the next episode, hitting BUY on that equity ETF. Stop and ask yourself just how profoundly this deep thinker has probed into the true drivers of valuations in recent years. More to the point, ask yourself whether the source is clean or compromised.

If you need inspiration, look to some of the greatest lines ever penned inPolitics and the English Language by George Orwell: “The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink.” And yes, Orwell was English. You can safely read his words aloud, with a British accent.